short_position

A short position (also known as 'short selling' or 'going short') is an investment strategy that speculates on the decline in a security's price. It's the polar opposite of the more common long position, where an investor buys a stock hoping its value will increase. When you “short” a stock, you are essentially betting against the company. The process involves borrowing shares of a stock you don't own, immediately selling them on the open market, and then hoping to buy them back later at a lower price. The profit is the difference between the price you sold the borrowed shares for and the lower price you paid to buy them back. While it sounds like a clever way to profit from a falling market, shorting is one of the riskiest maneuvers in investing. It carries unique dangers that can lead to catastrophic losses, making it a strategy that most long-term value investors, including legends like Warren Buffett, tend to avoid.

Selling something you don't own sounds a bit like magic, but it's a well-established process facilitated by brokers. Here’s how it works, step-by-step:

First, you need to find someone willing to lend you the shares you want to short. This is typically handled by your brokerage, which borrows the shares from its own inventory or from another client's margin account. This isn't a free service; you will have to pay interest, known as borrowing fees, to the lender for the duration of your short position.

Once the shares are borrowed, your broker immediately sells them at the current market price, just like any other sale. The cash from this sale is credited to your account. For example, if you borrow and sell 100 shares of Company XYZ at €50 per share, your account is credited with €5,000 (minus commissions).

To close your short position, you must buy back the same number of shares you initially borrowed. This is called 'covering' your short. The goal is to do this after the stock price has fallen. If Company XYZ's stock drops to €30, you can buy back the 100 shares for €3,000.

The 100 shares you just repurchased are automatically returned to the lender, closing the loan. Your gross profit is the difference between your initial sale proceeds and your repurchase cost: €5,000 - €3,000 = €2,000. From this, you must subtract any borrowing fees and commissions to find your net profit.

While the potential for profit is clear, the risks associated with shorting are severe and can be financially devastating.

This is the single greatest danger of short selling. When you buy a stock (a long position), the most you can possibly lose is your initial investment—the stock price can't go below zero. With a short position, there is no theoretical limit to how high a stock's price can go. If you short a stock at €50 and it soars to €250, you are on the hook for a €200 per share loss. Since a stock's price can rise indefinitely, so can your potential losses.

Shorting is done in a special brokerage account that allows you to borrow (a margin account). If the shorted stock rises in price instead of falling, the losses in your account can mount quickly. If your account equity falls below a certain threshold, your broker will issue a margin call, demanding you deposit more cash or close your position immediately by buying back the shares at a significant loss.

A short squeeze is a short seller's worst nightmare. It occurs when a heavily shorted stock starts to rise rapidly. The initial price increase forces some short sellers to cover their positions by buying back shares. This buying pressure drives the stock price even higher, which in turn forces more short sellers to buy, creating a vicious cycle of skyrocketing prices and catastrophic losses. The GameStop saga of 2021 is a famous modern example of this phenomenon.

Shorting isn't free. As mentioned, you pay borrowing fees. Furthermore, if the company whose stock you have shorted pays out dividends while you have the position open, you are responsible for paying those dividends to the person or entity you borrowed the shares from. These costs can eat away at profits or compound your losses.

The philosophy of value investing is built on a foundation of buying wonderful companies at fair prices and seeking a 'margin of safety'. Short selling is, in many ways, the antithesis of this approach.

• Asymmetrical Risk: Value investors love situations where the potential upside is much greater than the potential downside. Shorting is the exact opposite: your potential gain is capped (the stock can only go to zero), while your potential loss is infinite. This risk-reward profile is deeply unattractive to a classic value investor like Benjamin Graham.
• Timing the Market: Shorting requires you to be right about what will happen (the company will perform poorly) and when it will happen. As the economist John Maynard Keynes famously noted, “The market can remain irrational longer than you can remain solvent.” A horribly overvalued company can continue to get even more overvalued for years, wiping out any short seller who was right on fundamentals but wrong on timing.
• Focus on Negativity: Value investing is an optimistic pursuit focused on finding long-term success. Short selling requires a constant focus on failure, fraud, and decline. While some specialized hedge fund managers who follow value principles do engage in shorting, they are the exception, not the rule. For them, it is a tool used to bet against companies they believe have a flawed business model or fraudulent accounting, based on the same deep research used to find a company's intrinsic value.

For the average investor, the message from the masters is clear: stick to finding great businesses to own for the long term. The treacherous waters of short selling are best left to the most sophisticated (and daring) professionals.